New study blames Greek debt crisis on market panic

A new analysis of the Greek debt crisis claims to have
quantified what many people intuitively believed: That a spike in
debt prices in 2011 didn't reflect a rational market appraisal of
the country's economy, but a panic that worsened an already dire
situation.

It's still a preliminary analysis, and not something on which
policy should be based, but the underlying premise is intriguing.
Perhaps it's possible to determine precisely when markets tip from
equilibrium, a state in which prices reflect supply and demand,
into irrationality.

Over five months following the summer of 2011, the value of
Greek bonds -- financial instruments predicated on Greece's ability
to repay its loans -- plummeted from 57 per cent to 21 per cent of
face value, signalling a crisis of confidence among banks and
investors. The market had spoken, driving up interest rates on
existing loans, making it harder for Greece to borrow more money,
and increasing the likelihood of Greece defaulting altogether on
its debt.

Unresolved was the extent to which the bond market's
precipitously low valuation of Greek bonds actually reflected the
country's underlying problems, its decades of political misrule and culture of tax evasion, and how much was a self-perpetuating,
self-fulfilling panic.

"You look at the decline and say, 'This just doesn't make any
sense!' The economic conditions in Greece didn't change that much.
If the market's evaluation of the probability of default in August
was one in three, how can it become four in five just five months
later?" said Bar-Yam. "What do you do to scientifically disentangle
this?"

Bar-Yam and co-author Marco Lagi started by trying to find a
baseline, long-term relationship between bond prices and the various factors that might influence them: the size of
Greece's debt, the strength of its economy, consumer volatility,
and so on. If they could find such a relationship, it would
ostensibly show how the market behaved while in equilibrium.

Looking at the last decade, Bar-Yam and Lagi measured a very
close correlation between bond prices and the ratio of Greece's
debt to its economic productivity, or gross domestic product. This
debt-to-GDP ratio is one of many metrics used to assess national
solvency, but Bar-Yam and Lagi found that it mattered more than any
other.

This allowed them to infer how bond markets had estimated
Greece's risk over time. The risk had risen in a relatively linear
pattern since 2002, and followed a trajectory that pointed to
default in 2013. Until 2011, bond prices had predictably followed
this risk.

According to Bar-Yam and Yagi, the sudden divergence between
bond prices and default risk late in 2011, more than a year before
default was imminent, signified the market's transition from
rational calculation to irrational herd panic, with individual
investors reacting to each others' jitters rather than economic
fundamentals.

"The interest rates should have increased more rapidly, but they
shouldn't have gone haywire. They should have continued to follow
the curve," Bar-Yam said. "It's natural for people to panic
together, but now the market's out of equilibrium."

The implication, said Bar-Yam, is that Greek austerity
programmes -- budget cuts, reductions in social services, and other
belt-tightening national measures -- were perhaps harsher than they
needed to be, and may not have been so desperately required as
markets suggested.

Similar lessons might be applied to debt crises in Spain, Italy,
Portugal and Ireland. Moreover, to the extent that a Greek credit
default threatened the entire global economy, the threat had been
partly based on a panic.

"The potentially devastating consequences of a nation's default
for itself and the global community demonstrate the urgent need for
quantitative models [of market behaviour]," wrote Tobias Preis, a
professor of finance and behavioural science at the University of
Warwick, in an email. Preis called the analysis "new and
illuminating".

Jeffrey Fuhrer, researcher director at the Federal Reserve Bank
of Boston, struck a cautionary note. "I wouldn't ever take the
predictions from a single exercise like that too literally," Fuhrer
said. "Proving deviation from equilibrium is a tricky thing to
do."

With that caveat, Fuhrer applauded the analysis. "They uncover
what is an intuitively appealing relationship. It helps you
quantify some of the things that people believe are happening
qualitatively," he said.